Solutions to Chapter 4 Measuring Corporate Performance
1. a. Long-term debt ratio 0.42
724 , 9 018 , 7 018 , 7
b. Total debt ratio 0.65
714 , 27 178 , 6 018 , 7 794 , 4
c. Times interest earned 3.75 685
566 ,
2
d. Cash coverage ratio 7.42
685 518 , 2 566 , 2 e. Current ratio 0.74 794 , 4 525 , 3 f. Quick ratio 0.52 794 , 4 382 , 2 89
g. Operating profit margin 0.151 15.1% 193 , 13 685 311 , 1 h. Inventory turnover 19.11 2 / ) 238 187 ( 060 , 4
i. Days sales in inventory 19.10days
365 / 060 , 4 2 / ) 238 187 (
j. Average collection period 67.39days
365 / 193 , 13 2 / ) 490 , 2 382 , 2 ( k. Return on equity 0.129796 13% 2 / ) 121 , 9 724 , 9 ( 223 , 1
l. Return on assets 0.069 6.9% 2 / ) 503 , 27 714 , 27 ( 685 223 , 1 m. Return on capital % 67 . 11 116712 . 0 2 / )] 121 , 9 833 , 6 ( ) 724 , 9 108 , 7 [( 685 223 , 1 n. Payout ratio 0.699918 223 , 1856 Est time: 11–15
2. Market capitalization = ($84 × 205,000,000) = $17.22 billion
Market value added = $17.22 billion – $9.724 billion = $7.496 billion Market-to-book ratio = $17.22 billion/$9.724 billion = 1.77
Est time: 01-05
3. All values in millions.
EVA = after-tax interest + net income – (cost of capital × total capitalization) = [$685*(1 – 0.35)] + $1,223 – [8.3% × ($7,108 + $9,724)] = $278.664 Est time: 01–05
4. All values in millions.
a. EVA = after-tax interest + net income – (cost of capital × total capitalization) = [676 × (1 – 0.35)] + $2,661 –[.08 × (9,667 + 17,777)] = $904.88 EVA fell, since the cost of equity is higher.
b. Accounting profits are unaffected by changes in the cost of equity.
c. Economic value added is a better measure of company performance because accounting profits do not include all costs; specifically, the cost of equity capital. Est time: 01–05
5. a. MVA = market value of shares – book value of equity = $46,192 – 19,393 = $26,799
MVA fell as the market value of the shares dropped 5% b. No, the expected return on all shares has risen.
c. Yes, the cost of equity capital has increased for Pepsi. Est time: 01–05
6. a. Sustainable growth rate = plowback ratio × ROE
= 0.78 × 0.15 = 0.117, or 11.7%
Home Depot’s sustainable growth rate will rise with the higher plowback ratio. b. Sustainable growth = 0.43 × 0.14 = 0.0602, or 6%
The sustainable growth rate will fall. Est time: 01-05 7. Return on assets 0.069 6.9% 2 / ) 503 , 27 714 , 27 ( 685 223 , 1 Asset turnover 0.4779 47.79% 5 . 608 , 27 193 , 13 assets total average sales
Operating profit margin 0.1446 14.46%
193 , 13 685 223 , 1 sales interest income net
Asset turnover operating profit margin = 0.4779 0.1446 = 0.069 = ROA Est time: 06–10 8. Return on equity 0.129796 13% 2 / ) 121 , 9 724 , 9 ( 223 , 1 interest income net income net sales nterest i income net assets sales Equity Assets % 13 129796 . 0 685 223 , 1 223 , 1 193 , 13 685 223 , 1 5 . 608 , 27 193 , 13 5 . 422 , 9 5 . 608 , 27
(Notice that we have used average assets and average equity in this solution.) Est time: 06–10
9. a. The consulting firm has relatively few assets. The major “asset” is the know-how of its employees. The consulting firm has the higher asset turnover ratio. b. The Catalog Shopping Network generates far more sales relative to assets
since it does not have to sell goods from stores with high expenses and probably can maintain relatively lower inventories. The Catalog Shopping Network has the higher asset turnover ratio.
b. The supermarket has a far higher ratio of sales to assets. The supermarket itself is a simple building and the store sells a high volume of goods with relatively low markups (profit margins). Standard Supermarkets has the higher asset turnover.
Est time: 06-10
10. ROC = after-tax operating income/equity, or After-tax operating income = ROC × equity
EVA = after-tax operating income – (cost of equity × equity), substituting EVA = (ROC × equity) – (cost of equity × equity), or
EVA = equity × (ROC – cost of equity)
Thus, EVA is positive if ROC exceeds the cost of equity. Est time: 06–10 11. a. Debt-equity ratio equity debt term -long b. Return on equity equity average income net
c. Operating profit margin
sales interest income net d. Inventory turnover inventory average sold goods of cost e. Current ratio s liabilitie current assets current
f. Average collection period sales daily average s receivable average g. Quick ratio s liabilitie current s receivable securities marketable cash Est time: 01–05
12. If HD borrows $300 million and invests the funds in marketable securities, both current assets and current liabilities will increase.
a. Liquidity ratios: Current ratio 1.332 300 363 , 10 300 900 , 13 Quick ratio 0.2591 300 363 , 10 300 964 421 , 1 Cash ratio 0.1661 300 363 , 10 300 421 , 1
The transaction would result in a slight decrease in the current ratio and an increase in the quick ratio and the cash ratio, so the company might appear to be more liquid. However, a financial analyst would be very unlikely to conclude that the company is actually more liquid after engaging in such a transaction.
b. Leverage ratios:
The long-term debt ratio and the debt-equity ratio would be unaffected since current liabilities are not included in these ratios. The total debt ratio will increase slightly, however: 5329 . 0 300 877 , 40 300 484 , 21 assets Total s liabilitie Total
The very slight increase in the total debt ratio indicates that the company would
appear to be very slightly more leveraged. However, a financial analyst would
conclude that the company is actually no more leveraged than prior to the transaction.
13. a. Current ratio will be unaffected. Inventories are replaced with either cash or accounts receivable, but total current assets are unchanged.
b. Current ratio will be unaffected. Accounts due are replaced with the bank loan, but total current liabilities are unchanged.
c. Current ratio will be unaffected. Receivables are replaced with cash, but total current assets are unchanged.
d. Current ratio will be unaffected. Inventories replace cash, but total current assets are unchanged.
Est time: 01–05
14. The current ratio will be unaffected. Inventories replace cash, but total current assets are unchanged. The quick ratio falls, however, since inventories are not included in the most liquid assets.
Est time: 01–05
15. Average collection period equals average receivables divided by average daily sales:
Average collection period 236days
365 / 800 , 9 333 , 6 Est time: 01–05
16. Days sales in inventories 2days
365 / 000 , 73 400 Est time: 01–05
17. Annual cost of goods sold = $10,000 365/30 = $121,667
Inventory turnover 12.167 000 , 10 667 , 121
times per year
18. a. Interest expense = 0.08 $10 million = $800,000 Times interest earned = $1,000,000/$800,000 = 1.25
b. Cash coverage ratio 1.5
000 , 800 000 , 200 000 , 000 , 1
c. Fixed payment coverage 1.09
000 , 300 000 , 800 000 , 200 000 , 000 , 1 Est time: 01–05
19. a. ROA = asset turnover operating profit margin = 3 0.05 = 0.15 = 15% b. If debt/equity = 1, then debt = equity, so total assets are twice equity.
ROE ROA equity assets debt burden 0.10 10% 000 , 8 000 , 20 000 , 8 000 , 8 000 , 20 15 . 0 1 2 Est time: 06–10 20. Total sales = $3,000 365/20 = $54,750 Asset turnover ratio = $54,750/$75,000 = 0.73
ROA = asset turnover operating profit margin = 0.73 0.05 = 0.0365 = 3.65% Est time: 01–05 21. Debt-equity ratio equity debt term -long 000 , 000 , 1 $ debt term -long 4 . 0 long-term debt = 0.4 $1,000,000 = $400,000 0 . 2 s liabilitie Current assets Current
and current assets = $200,000
Total assets = total liabilities + equity = $500,000 + $1,000,000 = $1,500,000 Total debt ratio = $500,000/$1,500,000 = 0.33
Est time: 06–10 22. 0.5 equity Book debt Book 2 equity Book equity Market 25 . 0 2 5 . 0 equity Market debt Book Est time: 01–05
23. EBIT = revenues – COGS – depreciation
= $3,000,000 – $2,500,000 – $200,000 = $300,000 Interest = 8% of face value = $80,000
Times interest earned = $300,000/$80,000 = 3.75 Est time: 01-05
24. The firm has less debt relative to equity than the industry average, but its ratio of EBIT plus depreciation to interest expense is lower. Perhaps the firm has a lower ROA than its competitors and is therefore generating less EBIT per dollar of assets. Perhaps the firm pays a higher interest rate on its debt. Or perhaps its depreciation charges are lower because it uses less capital or older capital.
Est time: 01–05
25. A decline in market interest rates will increase the value of the fixed-rate debt and thus increase the market-value debt-equity ratio. By this measure, leverage will increase. The decline in interest rates will also reduce the firm’s interest payments on the floating-rate debt, which will increase the times interest earned ratio. By this measure, leverage will decrease. The impact of the lower rates on “leverage” is thus ambiguous. The firm has higher indebtedness relative to assets but greater ability to cover its cash-flow obligations.
26. a. The shipping company, which has more tangible assets, will tend to have the higher debt-equity ratio. (See Chapter 15, Sections 15.3 and 15.4, for a discussion of the reasons that firms holding tangible assets with active secondary markets tend to maintain higher debt-equity ratios.)
b. United Foods is in a more mature industry and probably has fewer favorable opportunities for reinvesting income. We would expect United Foods to have the higher payout ratio.
c. The paper mill will have higher sales per dollar of assets. It is less capital-intensive (that is, has less capital per dollar of sales) than the integrated firm.
d. The discount outlet sells many of its goods for cash. The power company bills monthly and usually gives customers a month to pay bills and therefore will have the longer collection period.
e. Fledging Electronics will have the higher price-earnings multiple, reflecting its greater growth prospects.
Est time: 06–10
27. Leverage ratios are of interest to banks or other investors lending money to the firm. They want to be assured that the firm is not borrowing more than it can reasonably be expected to repay.
Liquidity ratios are also of interest to creditors who prefer that a firm’s current assets are well in excess of its current liabilities. Liquidity ratios are especially important to those who lend to the firm for short periods, for example, by extending trade credit. If a firm buys goods on credit, the seller wants to know that, when the bill comes due, the firm will have enough cash on hand to pay it.
Efficiency ratios might be of interest to stock market analysts who want to know how well the firm is being run. These ratios are also of great concern to the firm’s own management, which needs to know if it is running as tight a ship as its competitors.
28. Income statement:
Millions of Dollars
Net sales $170.00
Cost of goods sold 130.00
Selling, general, & administrative expenses 10.00
Depreciation 20.00
EBIT 10.00
Interest expense 1.25
Income before tax 8.75
Tax 3.0625
Net income $5.6875
Balance sheet:
Millions of Dollars This Year Last Year
Assets
Cash and marketable securities $ 11 $ 20
Receivables 44 34
Inventories 22 26
Total current assets 77 80
Net property, plant, equipment 38 25
Total assets $115 $105
Liabilities & Shareholders’ Equity
Accounts payable $ 25 $ 20
Notes payable 30 35
Total current liabilities 55 55
Long-term debt 24 20
Shareholders’ equity 36 30
Total liabilities &
shareholders’ equity $115 $105
Solution procedure:
1. Total current liabilities = 25 + 30 = 55 2. Total current assets = 55 1.4 = 77 3. Cash = 55 0.2 = 11
4. Accounts receivable + cash = 55 1.0 = 55 5. Accounts receivable = 55 – cash = 55 – 11 = 44 6. Inventories = 77 – 11 – 44 = 22
7. Total assets = total liabilities and shareholders’ equity = 115 8. Net property, plant, equipment = 115 – 77 = 38
9. Sales = (365/avg. collection period) beginning receivables = (365/73) 34 = 170
10. Cost of goods sold = inventory turnover beginning inventory = 5.0 26 = 130
11. EBIT = 170 – 130 – 10 – 20 = 10
12. Interest = EBIT/times interest earned = 10/8 = 1.25
13. Tax = (EBIT – interest) 0.35 = (10 – 1.25) 0.35 = 3.0625 14. Net income = EBIT – interest – tax = 10 – 1.25 – 3.0625 = 5.6875 15. LT debt = LT debt ratio (total assets – current liabilities
= 0.4 (115 – 55) = 0.4 60 = 24 16. Shareholders’ equity = 60 – 24 = 36 Est time: 16–20
29. a. See table and graph below.
Profit Margin (%) Asset Turnover All manufacturing 5.19 0.77 Food products 7.99 1.19 Clothing 6.99 2.01 Beverage & tobacco 3.20 2.82 Chemicals 9.04 0.48 Drugs 11.00 0.38 Machinery 6.15 0.70 Electrical 8.02 0.59 Motor vehicles (0.42) 0.98 Computer and electronic 4.92 0.59 Paper 7.96 0.89
Asset turnover declines as operating profit margin rises. This relationship makes sense as firms with low profit margins need to generate more volume. That is, if margins are low, each dollar of total assets must work harder to produce the same amount of total profit.
b. See table and graph below
Current Ratio Quick Ratio All Manufacturing 1.43 1.03 Food Products 1.4 0.84 Clothing 1.39 0.54 Beverage & Tobacco 1.15 0.52 Chemicals 1.36 1.04 Drugs 1.56 1.28 Machinery 1.32 0.9 Electrical 1.1 0.72 Motor Vehicles 0.99 0.77 Computer and Electronics 1.94 1.64 Paper 1.27 0.9
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 0 0.5 1 1.5 2 2.5 Qu ic k Ratio Current Ratio
These two measures of liquidity appear to move together. Higher quick ratios are associated with higher current ratios. You may conclude that once you know one of these ratios there is little to be gained by calculating the other. However, analysts should use caution as some firms may have a high current ratios but the result may be due to a high level of illiquid assets, such as old inventory.
Est time: 11–15
30. If company X does not raise any new finance during the year but generates a lot of earnings during the year that are immediately reinvested, it makes more sense to use starting capital when calculating X’s return on capital. Return on capital is
understated if average capital is used. The answer would change if X made a large issue of debt early in the year. In this case it would be better to use an average of starting and ending capital.
For example, suppose company X has after-tax operating income of $3 million for the year. The starting capital was $30 million, composed of $10 million in long-term debt and $20 million in equity. Using starting capital, the X gives return on capital of 10%. If equity at year-end is $23 million, average capital is $31.5 million and return on capital is understated at only 9.5%.
The answer changes if X made a large issue of debt early in the yearbecause the new debt increases after-tax income from the debt shield. When a company’s additional financing during the year contributes a significant part of the year’s operating income, it’s better to divide by the average of the total capitalization at the beginning and end of the year.
Est time: 06–10
Solution to Minicase for Chapter 4
You will find an Excel spreadsheet solution for this minicase at the Online Learning Center (http://www.mhhe.com/bmm7e).
Problems for HH are apparent in the areas of debt and assets. Leverage ratios improved between 2003 and 2007, but debt (both long-term and short-term) has increased
significantly in 2008. Liquidity ratios began to deteriorate in 2007, at the same time that the number of employees increased substantially. Further deterioration in liquidity ratios occurred in 2008, when inventories more than doubled and current liabilities increased by more than 85%. At the same time, sales remained virtually unchanged from 2007.